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The True Cost of Foreign Withholding Taxes

Back in the fall of 2012, I wrote a pair of blog posts about the impact of foreign withholding taxes in US and international equity funds. The first explained the general idea of this tax on foreign dividends, while the second showed which funds are best held in which types of account (RRSP, TFSA, non-registered). This is a complicated and confusing topic, so I was surprised at the enormous interest these articles generated from readers, the media, advisors and even the ETF providers themselves.

What was missing from those articles, however, was hard numbers: it’s one thing to say this fund is more tax-efficient than that one, but by how much? To my knowledge no one has ever quantified the costs of foreign withholding tax in a comprehensive way—until now. Justin Bender and I have done this in our new white paper, Foreign Withholding Taxes: How to estimate the hidden tax drag on US and international equity index funds and ETFs.

The factors that matter

The amount of foreign withholding tax payable depends on two important factors. The first is the structure of the ETF or mutual fund. Canadian index investors can get exposure to US and international stocks in three ways:

through a US-listed ETF

through a Canadian-listed ETF that holds a US-listed ETF

through a Canadian-listed ETF or mutual fund that holds the stocks directly

The second key factor is the type of account: RRSPs, personal taxable accounts, corporate accounts, TFSAs and RESPs are vulnerable to foreign withholding taxes in different ways. Their impact in corporate accounts, in particular, was little understood until Justin delved deeply into this matter with the expert help of Charles Berry, an accountant at Welch LLP.

We examine eight different fund structures in the paper, and for each one we estimate the total cost of a representative fund by adding the fund’s management fees to the foreign withholding taxes that apply in each account type. We’ll forgive you if you want to skip all the formulas and cut to the chase, and we’ve presented our estimates for many popular ETFs in a table at the end of the paper. Here’s a small sample:

US Equities

Market

RRSP

TFSA

Taxable

Vanguard Total Stock Market (VTI)

US

0.05%

0.32%

0.05%

Vanguard US Total Market (VUN)

CDN

0.44%

0.44%

0.17%

TD US Index – e-Series (TDB902)

-

0.65%

0.65%

0.35%

Developed Markets Equities

Market

RRSP

TFSA

Taxable

Vanguard FTSE Developed Markets (VEA)

US

0.31%

0.68%

0.31%

Vanguard FTSE Developed ex N. America (VDU)

CDN

0.90%

0.90%

0.53%

BMO MSCI EAFE (ZEA)

CDN

0.67%

0.67%

0.34%

iShares MSCI EAFE IMI (XEF)

CDN

0.94%

0.94%

0.56%

TD Int’l Index Fund – e-Series (TDB911)

-

0.84%

0.84%

0.51%

Emerging Markets Equities

Market

RRSP

TFSA

Taxable

Vanguard FTSE Emerging Markets (VWO)

US

0.49%

0.85%

0.49%

Vanguard FTSE Emerging Markets (VEE)

CDN

1.05%

1.05%

0.69%

iShares MSCI Emerging Markets IMI (XEC)

CDN

1.00%

1.00%

0.68%

The first thing that jumps out is the large difference between US-listed and Canadian-listed ETFs when held in RRSPs. A fund like VUN is 39 basis points more expensive than VTI, while VDU adds an additional 59 basis points compared with VEA. In a large RRSP, therefore, it may be significantly more cost-effective to hold US-listed ETFs for your foreign equity exposure.

However—and this is important—this is only true if you can avoid the high cost of converting currency. If you’re investing relatively large sums and you’re comfortable doing Norbert’s gambit, then US-listed ETFs are an excellent option. But not everyone is keen to do this: in fact, after we explain the trade-off to clients of our DIY service, many decide they’re happy to pay more for the convenience of trading only Canadian-listed ETFs. And there’s nothing wrong with that decision.

Another important takeaway is that the tax advantages of US-listed equity ETFs are much smaller (or non-existent) in non-registered accounts. It probably makes sense for DIY investors to use Canadian-listed ETFs in their taxable accounts—even though their MERs are slightly higher—to avoid the cost of currency conversion.

Keep it in perspective

One of the common reactions to my earlier articles about foreign withholding taxes was to overestimate their significance. Let’s remember foreign equities are typically about 30% to 40% of a balanced portfolio, and the withholding taxes apply only to the dividends, which are likely to be in neighbourhood of 2% to 4%. So their impact on the overall portfolio may not be as large as you think.

Here’s an example of the cost breakdown in two versions of the Complete Couch Potato: the first uses US-listed ETFs for the foreign equities, while the second uses their Canadian-listed equivalents:

With US-listed ETFs

%

RRSP

TFSA

Taxable

Vanguard FTSE Canadian All Cap (VCN)

20%

0.14%

0.14%

0.14%

Vanguard Total Stock Market (VTI)

15%

0.05%

0.32%

0.05%

Vanguard FTSE Developed Markets (VEA)

10%

0.31%

0.68%

0.31%

Vanguard FTSE Emerging Markets (VWO)

5%

0.49%

0.85%

0.49%

BMO Equal Weight REITs (ZRE)

10%

0.62%

0.62%

0.62%

iShares DEX Real Return Bond (XRB)

10%

0.39%

0.39%

0.39%

Vanguard Canadian Aggregate Bond (VAB)

30%

0.22%

0.22%

0.22%

Total cost

0.26%

0.35%

0.26%

With Canadian-listed ETFs

%

RRSP

TFSA

Taxable

Vanguard FTSE Canadian All Cap (VCN)

20%

0.14%

0.14%

0.14%

Vanguard US Total Market (VUN)

15%

0.44%

0.44%

0.17%

Vanguard FTSE Developed ex N. America (VDU)

10%

0.90%

0.90%

0.53%

Vanguard FTSE Emerging Markets (VEE)

5%

1.05%

1.05%

0.69%

BMO Equal Weight REITs (ZRE)

10%

0.62%

0.62%

0.62%

iShares DEX Real Return Bond (XRB)

10%

0.39%

0.39%

0.39%

Vanguard Canadian Aggregate Bond (VAB)

30%

0.22%

0.22%

0.22%

Total cost

0.40%

0.40%

0.31%

I would argue that in a TFSA or taxable account the difference is trivial, and Canadian-listed ETFs are almost certainly the better choice. Even in an RRSP, the total difference of 14 basis points is not likely to outweigh the cost of currency conversion in smaller accounts.

In the end, it’s up to you to decide whether it’s worth using US-listed ETFs for your foreign equity holdings. But least now you have the numbers to help you make that choice.

134 Responses to The True Cost of Foreign Withholding Taxes

@CCP: I am adding money to my portfolio and after reading your posts regarding Swap-Based ETFs, I was wondering if it would be a good idea to sell my holdings of VCN and purchase HXT in my taxable account, even if it means realizing a capital gain?

@Harrison: There is no right or wrong answer: it simply depends whether you’re willing to pay the tax now or you’d rather defer it. Part of this will depend on whether you expect you may have a loss in the future that would offset the gain. You should also consider whether you might be in a lower tax bracket in the future, which would be an argument for deferring it longer.

@LawrenceW: That is always a possibility. However, swaps are different from the forward agreements used by the “advantaged” funds that the government targeted. They have been around for a long time in Canada and are widely used by institutional investors. As I understand it, there is no black magic behind them, just a tax arbitrage strategy.http://thewealthsteward.com/2010/10/a-closer-look-at-betapros-dirt-cheap-etf/

Quick question: Wouldn’t Canadian listed ETF’s have to (eventually) convert C$ inflows into US$ to be able to invest in US or international markets? Keeping that in mind, wouldn’t, by design, there be an act of converting C$ to US$. Thus, if the conversion is going to occur anyways, why not go for a fund with lower overall expenses (mostly US funds listed in US$).

@Omar: Yes, Canadian ETFs and mutual funds need to convert currency to buy foreign stocks. But buying US-listed ETFs means you have to convert the currency. Who do you think gets a better exchange rate?

Hello,
To clarify, the tax on VTI and VUN would be equal in a non-registered account, correct?

I saw your excel sheet where you were comparing the two and had a 15% withholding tax for the Canadian one but not the US one, but I assume that was only for an RRSP account?
Please correct me if I’m wrong. Thank you,
Lindsay

@Lindsay: That’s right, the foreign withholding tax treatment is the same in a non-registered account: in both cases the tax would be withheld, but it is recoverable by claiming the foreign tax credit. In an RRSP the foreign withholding tax would be lost with VUN.

Am I correct in assuming that RESPs (and RDSPs) work the same as TFSAs regarding taxation so the recommendations for TFSAs above apply equally for them?

Your 2012 article “Which Fund Goes Where?” talked about taxable accounts and RRSPs – but what about TFSAs/RESPs as they are somewhat different tax-wise? The main question I have is whether or not it is efficient to hold XMW (which just holds the US listed ETF ACWV) in an RESP? If not should I hold ACWV in that account which is a US listed ETF that holds US and international stocks.

@Zaphod: RESPs and TFSAs are addressed in the white paper: RDSPs get the same treatment. There is no exemption for foreign withholding taxes in these accounts, and the amounts are not recoverable. So whether you hold XMW or ACWV you will lose the foreign withholding tax in an RESP.

And do dividends from VFV and VUN etfs qualify for the Canadian dividend tax credit? (Canadian company, but holdings are in the States). (I doubt that will be a deciding factor for me, but I like going in with all the info I can get.)

In regard to U.S. witholding taxes on Canadian domiciled US Etf’s, it appears that the canadian currency version of HXS tracking the S&P 500 might be a good choice for registered accounts.
The etf information package clearly states the total return swap method results in avoidance of any U.S. taxes on this etf. The m.e.r. is also lower than VUN. Could you give me your thoughts on this? Thanks.

@Paul: There’s no free lunch. HXS carries a swap fee of 0.30% in addition to its MER, and that corresponds almost exactly to the expected withholding tax (based on 15% of a 2% yield). There may be a benefit to reducing the amount of income tax, but there is no impact on withholding taxes.

@Gordon: The management fee is not the same as the MER. The latter also includes taxes and other administrative fees and may vary slightly from year to year. Vanguard and iShares include both on their websites; BMO and others regrettably do not. You can always find the most recent MER by looking in the fund’s Management Report of Fund Performance. For ZRE, it was 0.62% for each of the last four years.

Hello CCP,
Where should VXUS and the new VXC be held for least MER hit? I always thought VXUS should be held in a RRSP. If I understand it correctly and with the way you have it, VXC should be held in a taxable account since it is a CDN listed ETF?

Would one recommend replacing VUN + VDU + VEE for the simplicity of just holding VXC?

@Bob: The MER is not the issue. The main difference is foreign withholding taxes. US-listed ETFs are more tax efficient when held in an RRSP. In a taxable account this is less of an issue, and there is a big benefit to trading in Canadian dollars.

I think you can make a good argument that holding a single fund for US, international and emerging markets is quite convenient if you hold all of those asset classes in the same account anyway.

Great posting.. I’m wondering if your thoughts are any different if I wanted to purchase purely ETFs that hold U.S. equities that pay out dividends (i.e. Vanguard VIG)?

Would it be likely my best option to purchase through a US-listed ETF (as opposed to a Canadian-listed ETF) through an RRSP account? This, IMO, would really be the only way to eliminate the withholding tax on the dividends, which would be relatively more significant than the Can. Couch Potato model portfolios mentioned since the ETF was dividend focused.

@Tommy: US-listed ETFs are always more tax-efficient in and RRSP and, as you say, this is even more of an advantage if the ETF has a higher than normal yield. As always, remember that US-listed ETFs also involve currency conversion costs that may outweigh the tax benefits.

@Derek: The reduction in foreign withholding tax always needs to be weighed against the added cost of transacting in US dollars. If you are paying high costs to convert currency in order to buy VTI and VWO then it’s not worth it. My guess is that it’s not worth switching at this point.

Am I missing something. Aren’t dividends from international stocks taxed at your marginal rate? For instance, earning $75k/year your marginal rate is 33%. So by putting these stocks in your TFSA you save paying the 33% which is much greater factor here than trying to save the 15% withholding tax.

@Andrew: You’re not missing anything: it’s just about putting then cart before the horse. Many investors who learn about foreign withholding tax assume the advice is to avoid using registered accounts for foreign equities. But as you point out, income tax (and therefore asset location) is much more important factor, and that decision comes first. Understanding foreign withholding taxes simply helps you select more tax-efficient products to get that foreign equity exposure.

If I own a Canadian ETF that holds international equities directly (e.g., XEF) in a non-registered account, then I understand that I would receive a tax slip indicating the foreign tax paid (by the ETF). I could then seek to recover the foreign tax by claiming the foreign tax credit. I’ve seen some info stating that the foreign tax credit must be calculated separately in respect of each country where the foreign tax was paid (and that if more than 3 countries are involved, one can’t use NetFile). Is this complication (calculating separately in relation to each country) a factor only where one holds different foreign equities directly (as opposed to holding an ETF), such that when holding something like XEF, one would instead simply receive a tax slip indicating one $ amount of foreign tax paid and then one would just use that one $ amount to claim the foreign tax credit? Great website. Very helpful.

Thanks for the response. If you have not seen this as an issue with respect to ETFs, then my guess is that it does not apply when holding ETFs. (Perhaps this would only apply when an individual owns foreign securities directly (as opposed to owning an ETF that owns foreign securities) and withholding tax is deducted from payments made directly to the individual). Below is a link to what I was looking at.